Registered Education Savings Plans (RESP) Basics – What You Need to Know
A Registered Education Savings Plan (RESP) is a special savings account established by the Canadian government to help parents save for their children child’s post secondary education after-secondary education. The unique aspect of an RESP is that it allows investments within the account to grow tax-free until the child is ready to go to college, university, or any other educational institution after high school. Additionally, the Canadian government provides grants to these plans to encourage parents to save for their child’s future education. earnings in an RESP generally grow to be free from taxation, as long as they remain within the plan.
Contributions to an RESP can be made by anyone—parents, grandparents, other family members, and friends. There is no annual limit on how much can be contributed tax year to an RESP, but there is a lifetime contribution limit of $50,000 per child. The Canadian government will match 20% of the first $2,500 contributed each year through the Canada Education Savings Grant (CESG), giving an additional $500 to the RESP. These generous contributions and benefits make RESPs a practical and beneficial strategy for saving towards a child’s future education.
RESP Tax Traps U.S. Filers Should Know
The Canada-US Tax Treaty, officially known as the “Convention between Canada and the United States of America concerning Taxes on Income and on Capital,” does not specifically protect Registered Education Savings Plans (RESPs). Therefore, although the growth of the income earned the investments in an RESP is tax-free in Canada, the United States does not recognize the tax-free status of RESPs. American citizens or resident aliens who are contributors or subscribers to an RESP might face tax implications in the US. The earnings in an RESP may be taxed by the US, and there may be further tax considerations if the subscriber has to file a US tax return. As tax laws can be complex and change frequently, it is always recommended to consult with a tax professional or advisor who is knowledgeable about the tax laws of both countries.
U.S. Foreign Trust Reporting Considerations and Relief for Canadian RESPs
From a US taxation perspective, Registered Education Savings Plans (RESPs) were previously frequently classified as foreign trusts. This designation results from the IRS’s definition of a foreign trust, which includes any arrangement where the principal purpose is the income’s accumulation or the distribution of funds, and the trustee or beneficiary has the power to control these funds.
In 2020, the IRS issued Rev. Proc. 2020-17, granting certain tax reporting exemptions for specific types of trusts, which potentially include RESPs. According to this Revenue Procedure, eligible individuals are exempt from Section 6048 Reporting Requirements for their transactions with, and ownership of, certain tax-favored foreign trusts. An RESP can be considered a tax-favored foreign trust under this revenue procedure if it meets specific criteria outlined by the IRS, such as being a trust established exclusively for tax purposes to provide for the education or medical expenses of the beneficiary.
However, while Rev. Proc. 2020-17 provides some relief from reporting requirements, it does not change the fact that income tax returns and the earnings in an RESP are subject to US tax. Consequently, even with this provision, US persons holding RESPs should consult with a tax professional to understand their potential tax obligations.
U.S. FBAR & FATCA Considerations for Canadian RESPs
RESPs can indeed fall under the reporting requirements for FBAR (Report of Foreign Bank and Financial Accounts). If the aggregate value of all foreign financial accounts, including an RESP, exceeded $10,000 at any point during the calendar year, the account holder, if they are a U.S. person, is obligated to report it on an FBAR. However, due to the intricacies of international taxation and frequent changes in tax laws, it’s highly recommended to consult with a tax professional or advisor to understand the specific, annual reporting requirements and obligations.
RESPs may also indeed be considered a specified foreign financial asset and may need to be reported on Form 8938. However, the reporting threshold for Form 8938 varies depending on the taxpayer’s residency status and filing status. Consequently, a taxpayer can be required to file an FBAR but not Form 8938.
U.S. Income Inclusion and Double-Taxation Issues for Canadian RESPs
RESPs pose potential double taxation risks for Americans due to the divergent ways the United States and Canada treat these accounts. While Canada recognizes RESPs as tax-advantaged education savings accounts, the United States views them as foreign trusts, subject to different tax and reporting rules. This mismatch means that while contributions, growth, and withdrawals may be tax-free or tax-deferred in Canada, they could be taxable in the US. For instance, the growth within the RESP, which is tax-free in Canada until withdrawal, would be subject to US tax in the year the income is earned.
How RESP Grants are Treated on a U.S. Tax Return
Additionally, any CESGs paid by the government into your child’s RESP are also taxable income due to you as their U.S. parent or grandparent who remains a subscriber. This is true despite the tax-deferred status in Canada. With the receipt of money from a CESG, a family could end up with another double tax issue if they don’t plan for their taxes.
U.S. PFIC Problems Canadians Should Know
Passive Foreign Investment Company (PFIC) tax rules, are another U.S. tax consideration for Registered Education Savings Plans (RESPs). PFICs are non-U.S. corporations, at least 75% of whose gross income is passive, or at least 50% of whose assets are investments producing passive income. The United States Internal Revenue Service (IRS) may classify certain investment vehicles, mutual funds, and ETFs held within RESPs, as PFICs. This can lead to onerous tax implications for U.S. persons, as gains realized on the sale of a PFIC are considered ordinary income, not capital gains, and are subject to the highest marginal tax rate. Additionally, these gains may also be subject to an interest charge.
Relief from U.S. Penalties for Canadian RESPs
The IRS has acknowledged the complex challenges faced by U.S. persons holding RESPs and other similar accounts in the Revenue Procedure 2020-17. To alleviate some of the burdens associated with reporting obligations, the IRS issued this new procedure that provides relief from penalties for certain tax-deferred foreign retirement and non-retirement savings accounts, which includes RESPs.
If the RESP account falls under the definition of a tax-favored foreign retirement trust or tax-favored foreign non-retirement savings trust as stated in the procedure, and the U.S. person is compliant with all reporting requirements related to distributions and contributions, they are generally exempt from the usually onerous filing requirements associated with foreign trusts.
Why U.S. Persons Should Consider Appointing a Canadian Subscriber to an RESP?
Given these complexities surrounding RESPs for U.S. persons, one approach to consider is appointing a Canadian subscriber to the RESP. By doing so, the U.S. person may be able to avoid some of the tax complications associated with U.S. tax laws regarding foreign gifts and PFIC rules. The appointed Canadian subscriber, who ideally would not be a U.S. person, would be the legal owner of the RESP, meaning that U.S. tax implications might not apply in the same way. This could potentially mitigate the risk of the RESP being treated as a foreign trust or a PFIC under U.S. tax law. However, this is a complex strategy that requires careful consideration and professional advice. U.S. persons must consult with a cross-border tax professional before proceeding with appointing a Canadian subscriber. This will help ensure that they fully understand the implications and potential risks associated with this strategy and that any decisions made are in compliance with both U.S. and Canadian tax laws.
This blog post provides a comprehensive overview of the tax implications and considerations for U.S. persons holding Registered Education Savings Plans (RESPs) in Canada. It delves into the complexities of U.S. and Canadian tax laws, highlighting how these laws perceive RESPs differently, potentially leading to double taxation.
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Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.
The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.